United States Pending Home Sales The index is at its lowest level since the housing market crash of 2008. Due to rising mortgage rates in 2022 and the continued rise in housing prices, homeownership affordability is also at its lowest level today. today at a record level. After almost reaching 8%, the average 30-year mortgage rate in the United States has fallen to just below around 6.7%, still creating affordability tensions but encouraging some bullish sentiment. That said, existing home sales continued to decline despite a slight improvement. See below:
Affordability levels, home sales volumes and median house price/income ratio These ratios are just as extreme, and often more extreme, than the levels seen during the peak of the housing bubble around 2006 and 2007. Mortgage rates and inflation are also about the same level today as they were back then. ‘era.
Given the similarity in trends, many might expect homebuilders to stocks suffer catastrophic declines, like in 2008. On the contrary, most homebuilders are performing well today. For example, M/I Homes (MHO) is up about 192% year-to-date and is trading more than 10 times above its post-GFC price and nearly 3 times above the peak price of the 2006 housing bubble. The company’s stock market performance this year is simply exceptional. See below:
Notably, the stock’s value has grown at an extreme rate while its EPS has stagnated over the past year. Indeed, its EPS growth between 2020 and the end of 2022 was tremendous, but it occurred primarily under the ultra-low mortgage rate paradigm, which does not exist today. Given this, it is possible that M/I Homes is rising not due to a fundamental improvement in the outlook, but due to speculative reasons that will likely result in a “boom and bust” cycle. Of course, there are also fundamental differences between the current real estate market and the period 2006-2008, which could improve its profitability in the coming years.
Bullish Factors Behind M/I Homes Rally
Short interest on MHO is currently around 4.12% (of shares outstanding), which is not a very high number. Nonetheless, it is superior to the typical stock and implies that some speculative activity is betting against it. Short interest has risen with the stock for most of the past year, implying that speculative bets against it have increased as its valuation has risen. The stock began to decline in the fall, but quickly reversed course as short interest levels declined. See below:
The decline in short interest combined with the sharp rise in stock prices is a telltale sign of a short squeeze, or at least a minor one. Most likely, those who shorted the stock as its value rose had lost a decent amount and were looking to close the trade during the fall decline, but may now rush in as the stock undergoes a massive rally. If an improvement doesn’t match this recovery in fundamentals, I don’t expect it to last.
Two economic factors primarily determine M/I’s gross profits: home sales volumes and home prices. Today, M/I’s gross profits are only up about 3.6% year-over-year, not a huge increase from its nearly 80% increase in 2021. Today, existing home sales volumes are low, while new home sales are about half the 2020 peak, but still much higher than after the housing crisis of the 2000s. That said, property prices continue to rise on an annual basis. See below:
Rising housing prices are the primary means by which M/I revenues have increased recently. The company’s overall sales have stagnated over the past year, but rising real estate prices have greatly improved its profit margins. Further away, price of construction materials have decreased since the peak of massive shortage of construction parts in 2021. Even though construction materials have not decreased over the past year, this factor has also improved the profitability of the construction sector. The stability of house prices probably comes from two factors. One of them is low inventory of single-family homes. Second, further increases in rental costs relative to inflation. Housing starts, while high, are also not as high today as they were at the peak of the bubble. See below:
While housing is now much less affordable due to rising prices and mortgage costs, rents are also extremely unaffordable after rising about 35% faster than inflation over the past two decades. There are also a few existing homes on the market. That said, it is worth noting that housing inventories have been increasing over the past few months, typically a prolonged season marked by declining housing inventories. Inventories typically bottom out in January, but they will be much higher in January 2024 than in January 2023. Although inventories are not expected to increase too quickly, this is a strong signal that house prices may not not maintain their stability.
What is M/I worth today?
The company has some means to protect itself against market risks. On the one hand, it is mainly focuses in the Southeastern United States and the Midwest, which are much more affordable markets than the West and Northeast. THE The southeast also has very high population growth rates as people migrate to more affordable areas. The company is also focusing on smaller, more affordable homes through its “Smart Series” program. According to the company, more than 50% of its buyers are first-time buyers, a very solid indicator given the general lack of new things buyers, especially in a context of higher mortgage rates. This cohort has a low homeownership levels but this will likely be a significant area of prolonged growth as this changes naturally.
Overall, I believe M/I’s focus on more profitable and growing geographic and demographic demand areas will improve stability in the years to come. That said, it is rare that housing can remain at “extremely low” affordability levels indefinitely. Against a backdrop of low pending sales, we are seeing an increase in inventory going against the seasonal trend. Although rent growth should continue to support housing demand, I think we are starting to see signs that housing prices will slow and potentially fall in the most expensive areas.
Surely this will result in a repeat of 2008? Not necessarily, but investors should not assume that M/I will continue to thrive. I’m not predicting a housing market crash at this point, especially among more affordable single-family residences in high-growth areas. Nonetheless, I do not expect the strength of 2021-2022 to continue amid higher mortgage rates. Indeed, M/I EPS and sales growth have stagnated over the past year, so it is unreasonable to assume that it will accelerate, given the continued decline in the economic fundamentals of the real estate market.
M/I’s EPS is very cyclical in that its profit margins fluctuate significantly with market trend. Typically, the company trades in a price/firm sale range between ~0.2X and ~0.6X, with a higher valuation only justified by the possibility of profit margin and expansion in revenue growth. sales. Today, its profit margins are around an all-time high, making it unlikely they will increase (technically falling), while its sales growth is stagnating and expected to continue to do so if inventories increase in 2024. So I don’t see any way to justify its high valuation premium today. See below:
MHO trades at a ~100% premium to its typical price/sale range. Its abnormally high profit margins justify some of this premium, but its margins are generally unlikely to remain this high as the market is in a peak cycle. The construction sector East cyclical, and MHO’s valuation is only justifiable if we assume it is not. Additionally, MHO’s inventory and debts are incredibly high today. See below:
These factors are about normal compared to its sales during the last quarter, but illustrate how the company is not preparing for a potential market downturn. The company continually reinvests its profits in new projects. While this is a great way to ensure decent growth, this practice almost killed the company in 2008 when its inventory was very high, leading to a downturn in the real estate market. If its profit margins are not maintained, M/I will have a substantial liability burden that may not be reasonably payable.
Overall, I am very bearish on MHO today as it appears to be rising in a speculative fervor, not supported by its fundamentals. M/I is a well-run company focused on expanding into a larger area of demand. The company has also seen meteoric EPS growth in recent years, mainly attributable to Goldilocks dynamics around 2021 due to meager mortgage rates.
Looking ahead, record low home affordability and weak sales are expected to lead to higher inventory and lower sales prices. M/I could face problems even if prices stagnate, as construction material and labor costs are unlikely to stagnate, causing its volatile margins to decline. The stock is trading at a considerable valuation premium, potentially due to a small squeeze that began toward the end of October. At the very least, I think the stock would be more fairly valued at its October price of around $76 per share. This price would give it a price-to-sales ratio of around 0.5X, which is well within its normal range and would reasonably account for the natural cyclicality of its profit margins.
I would not sell MHO today as it appears to be in a short position. However, this could change over the coming weeks if its technical momentum declines. Nonetheless, I am very bearish on MHO and expect it to likely trade closer to the ~$75 level by the end of 2024.